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Case 4: Forecasting

Gross Domestic Product (GDP) is a measure of overall activity in the


economy. It is defined as the value at the final point of sale of all goods and
services produced during a given period by both domestic and foreign-owned
enterprises. GDP and changes in GDP are sometimes reported in current-year,
or nominal, dollars. In 1993, for example, current-year GDP provides a useful
measure of productive output valued at then-current prices. However,
inflation that causes economy-wide changes in the price level can distort
nominal GDP figures and create a picture of robust activity when the economy
is actually sluggish. As a result, GDP and changes in GDP are also measured in
inflation-adjusted, or real, terms. When GDP is evaluated using constant 1987
dollars, the effects of economy-wide inflation are controlled, and the pace of
real economic activity is revealed. For this reason, inflation-adjusted GDP
figures are often referred to real GDP terms. Table 1 shows current-year and
real GDP figures for the U.S. economy for the 32-year period from 1959 to
1991.

GDP data for the entire 1959-1991 period offer the basis to test the
ability of a simple constant growth model to describe the trend in GDP over
time. However, such a regression model cannot be used to forecast GDP over
any subpart of that period. To do so would be to overstate the forecast
capability of the regression model since, by definition, the regression line
minimizes the sum of squared deviations over the estimation period. To test
forecast reliability, it is necessary to test the predictive capability of a given
model over data that was not used to generate the regression model. These
data offer an interesting basis for evaluating the usefulness of the simple
growth model approach to economic forecasting. In the absence of GDP data
for the 1991-1995 period, the reliability of alternative forecast technique can
be illustrated by arbitrarily dividing historical GDP data into two subsamples:
a 1959-1983 test group, and a 1984-1991 forecast group. A regression model
estimated over the test group can be used to forecast actual GDP over the
1984-1991 period. Estimation results over the 1959-1983 subperiod provide
a forecast model that can be used to evaluate the predicitive reliability of a
constant growth model over the 1984-1991 forecast period.
Table 1. Gross Domestic Product in Current-Year (Nominal)
Dollars and in 1987 Dollars, 1959-91

GDP in current GDP in 1987 dollars Time Period


Year
dollars (in billions) (in billions) (in years)
1991 5,671.8 4,848.4 33
1990 5,513.8 4,884.9 32
1989 5,244.0 4,836.9 31
1988 4,900.4 4,718.6 30
1987 4,539.9 4,540.0 29
1986 4,268.6 4,405.5 28
1985 4,038.7 4,279.8 27
1984 3,777.2 4,148.5 26
1983 3,405.0 3,906.6 25
1982 3,149.6 3,760.3 24
1981 3,030.6 3,843.1 23
1980 2,708.0 3,776.3 22
1979 2,488.6 3,796.8 21
1978 2,232.7 3,703.5 20
1977 1,974.1 3,533.2 19
1976 1,768.4 3,380.8 18
1975 1,585.9 3,221.7 17
1974 1,458.6 3,248.1 16
1973 1,349.6 3,268.6 15
1972 1,207.0 3,107.1 14
1971 1,097.2 2,965.1 13
1970 1,010.7 2,875.8 12
1969 959.5 2,877.1 11
1968 889.3 2,801.0 10
1967 814.3 2,690.3 9
1966 769.8 2,622.3 8
1965 702.7 2,473.5 7
1964 648.0 2,343.3 6
1963 603.1 2,218.0 5
1962 571.6 2,129.8 4
1961 531.8 2,025.6 3
1960 513.4 1,973.2 2
1959 494.2 1,931.3 1
A. Set up a table or spreadsheet with GDP data for the 1959-1991 period as
shown in the previous table. Transform these GDP data using natural
logarithms so that it will become possible to analyze them using a constant
growth model with continuous compounding.

B. Use the simple regression model approach to estimate, in turn, the linear
relationship between the natural logarithm of (1) nominal GDP and time,
and (2) real GDP (ln GDP) and time. Estimate each model over two time
intervals: the entire 1959-1991 period and the 1959-1983 test subperiod,
where
lnYt = b0+b1Tt+ut
and where lnYt is the natural logarithm of each respective measure of GDP
in year t, and T is a time trend variable (where T1 = 1959, T2 = 1960, T3 =
1961,…, and T25 = 1983); and u is a residual term that includes the effects
of all factors that have been omitted from the regression models and the
effects of random or stochastic elements. These are called constant growth
models because they are based on the assumption of a constant percentage
growth in economic activity per year. How well does each constant growth
model fit actual GDP data?

C. Create a spreadsheet that shows actual and forecast GDP values for the
1984-1991 period. Each GDP forecast is derived using the coefficients
estimates for each model in Part B along with values for each respective
time trend variable over the 1984-1991 period. Remember that T26 = 1984,
T27 = 1986, T28 = 1987,…, and T33 = 1991 and that each constant growth
model provides predicted, or forecast, values for the relevant lnYt variable.
To obtain values for Yt, simply take the antilog (exponent) of each
predicted lnYt variable. Place these forecast values in the spreadsheet
alongside actual figures. Then, subtract actual figures from forecast values
to obtain annual estimates of forecast error for each Yt variable, plus an
estimate of average forecast error for each Yt variable over the 1984-1991
period.

D. Compute the correlation coefficient between actual and forecast values for
each Yt variable over the 1984-1991 period. Also compute the sample
mean forecast error for each Yt variable. Based on these findings, how well
do constant growth models generated using data over the 1959-1983
period forecast actual GDP data over the 1984-1991 period?